Volatility is back. Are you prepared?

Monthly Investment Letter

Former CIA Director and commander of US forces in Afghanistan, David Petraeus, recently spoke with some of our clients about the strategic importance of “getting the big things right.” He made a powerful point. But while nobody would disagree with his idea, implementing it is far from straightforward. First, you have to know what the big things are. Then you also have to know which ones you stand a chance of getting right before planning your work and working your plan.

After many years of a bull market, many clients are asking about timing their exit from equities. Some have already done so. While I agree that market timing is a “big thing,” I always question if, realistically, these clients are focusing on the most effective way to protect and grow their wealth.

First, you have to know what the big things are. Then you also have to know which ones you stand a chance of getting right before planning your work and working your plan.

What if you had a crystal ball and knew with 100% certainty that the bull market would end in the next 12 months? Would you still be skilled enough to achieve higher returns than a buy-and-hold investor? Markets are volatile around turning points, so the risk of a costly mistake by exiting them too early is high. Since 1928, average returns in the final year of a bull market have been 22%. Average annualized drawdowns in a bear market have been 30%. And the average rally in the first year of a bull market has been 40%. Since 1936, an investor with relatively good market timing, able to consistently sell 10 months before a market peak and buy back 10 months after a trough, would still have ended up worse off than the investor who remained invested throughout the period, even before taxes and trading costs.

Over the course of a lifetime of financial cycles, I don’t think that market timing is the “big thing” that investors should attempt, given the risks of getting it wrong. Staying invested pays off in the long term. Furthermore, we believe that global economic expansion, strong corporate profit growth, and reasonable valuations should support equities over the shorter term. But, as I discuss in greater detail in this letter, there are a number of “big things” that investors can implement right now, which stand a good chance of helping prepare portfolios for a more volatile investment environment.

First, diversify portfolios beyond a passive equity and bond strategy. Bonds and equities can rise and fall together at turning points in monetary policy, so this is a time when adding exposure to alternatives, like hedge funds or private markets, can help reduce portfolio volatility.

Second, add protection against falling markets. Drawdowns will be larger and more frequent in 2018 than in 2017.

Third, improve credit quality. “High yield” as a category no longer compensates for the risks, in our view. The recent rise in high quality bond yields offers a potentially good replacement. Fourth, diversify country and sector risks. Fifth, invest over the long term in companies, sectors, and themes exposed to secular growth drivers, such as urbanization, population growth, and aging.

In our FX strategy, we make a number of changes this month to manage risk in our portfolio. Near-term uncertainty over US interest rates and Eurozone growth prompted us to close our overweight position in the euro relative to the US dollar (USD) and wait for a better entry point. Additionally, we close our overweight in the Brazilian real (BRL) relative to the US dollar, and our overweight position in the Japanese yen (JPY) relative to the New Zealand dollar (NZD). Within international developed equities, we also introduce a new tactical overweight to Canadian equities relative to Swiss equities.

Five strategies to prepare for a choppier bull market

We don’t believe that the equity bull market is over. But we are unlikely to return to the era of low volatility since policy uncertainty has increased as the economic cycle has matured. Investors should adopt a number of strategies to ensure they are well-prepared for this new environment.

Looking beyond passive approaches

Ordinarily, equities and bonds can be expected to move in opposing directions on a day-to-day basis. But during periods of market uncertainty over monetary policy, the two asset classes can rise and fall together, increasing the volatility of traditional equity-bond portfolios. We have seen this dynamic at work already this year, most notably in February, when equities dropped alongside bonds. Looking ahead, upward surprises in inflation or changes to the US Federal Reserve’s estimate of long-term real interest rates could lead to a repeat of this dynamic. While we believe that a negative correlation between bonds and equities will likely hold over the medium to long term, investors holding only passive bond and equity indexes should expect to see higher volatility in the short term. This makes exposure to less-correlated strategies important in stabilizing portfolios.

One option is for investors to look to hedge funds, which have historically outperformed during periods of rising US interest rates and in the later stages of the economic cycle (see Fig. 1).

Investors can also look to strategies that invest in stocks based on factors such as momentum, quality, size, volatility, value, and dividends. Such “smart beta” strategies have been shown to outperform standard equity indexes, and can be less correlated to broader market moves.

Building in downside protection

In 2017, global equities did not fall by more than 2% at any point. But within the first two months of 2018, we already had a drawdown of 9% (see Fig. 2). Daily volatility has also increased: 2018 has already seen 11 days with drawdowns in excess of 1%, compared to just two days in all of 2017. We believe it remains important to retain exposure to market upside, given strong economic and earnings growth. But in a year with greater downside risk, it is also valuable for investors to insure portfolios against market falls.

For those investors who can use options, put strategies can help mitigate downside risk. However, it is important to be selective because insurance can be costly. In some cases, less-known markets (Eurozone, Italian, or Hong Kong equity indexes) could provide more “bang for your buck” than options on the S&P 500. We would recommend against taking out insurance on more than a small part of the portfolio, since we still advise a risk-on stance tactically.

Improving credit quality

Over close to a decade of near-zero (or sub-zero) interest rates, many investors have tried to earn higher yields by investing in riskier companies. During periods of low volatility and infrequent corporate defaults, such strategies can work well. Since the end of December 2009, US high yield credit delivered annualized returns of 7.5%. But at times of higher volatility such positions are potentially risky. Yields on “high yield” credit are no longer high: if they were to increase by just 1.1% a full year’s worth of return on US dollar-denominated BB-rated bonds would be erased. The good news is that yields on higher quality bonds have recently been increasing, and can provide an effective substitute for high yield credit in a portfolio context (see Fig. 3). Ten-year US high grade bonds currently yield around 3.3%, and should be expected to rally if global growth disappoints, or geopolitics produces a shock. We are currently overweight 10-year US Treasuries in our global tactical asset allocation.

Diversifying concentrated holdings

In my October 2017 letter, Dealing with Disaster, I looked through various historical examples of wealth destruction, ranging from hyperinflations, to wars, revolutions, and government defaults. Each of these disasters proved to be local, or at most regional, in nature. Investors able to diversify assets globally would have been able to avoid the worst.

While we are not forecasting any of the above, holding a globally diversified portfolio still makes sense as it reduces exposure to specific risks at a time when different regions are at different stages of their economic, monetary policy, and debt cycles. The portfolios of investors with more globally diversified holdings also tend to be more stable. Since the start of 2018, the S&P 500 has endured 32 daily moves of greater than 1%. The MSCI AC World Index has seen 40% fewer.

Thinking long term

At a time of heightened uncertainty about the economic cycle, buying assets with exposure to secular growth drivers can help improve portfolio performance and reduce risk. This includes buying companies that benefit from trends like urbanization, population growth, and aging. We expect such firms to generate above-average revenue growth through an economic cycle. Companies exposed to these growth drivers might also be expected to perform better in the event of a downturn. The Longer Term Investments (LTI) series outlines investment strategies that can allow investors to tap into these opportunities.

Looking outside of public markets and gaining exposure to private equity and debt can also enable investors to capture different sources of return. Private markets compensate investors for tying up their money for longer time periods – we estimate the “illiquidity premium” is worth 2–4% per annum. Locking money away can also help reduce the temptation for investors to sell during periods of volatility. Behavioral finance studies show that panic selling is an important source of the long-term underperformance of private investors relative to market benchmarks.

We also believe that investing in a way that has a positive impact on society and the environment need not cost investors returns, and can even enhance them.

Global tactical asset allocation

Over our six-month tactical investment horizon few numbers are more important than the US Treasury yield, and, by extension, few things are more important than the factors which influence it – US inflation, and estimates of long-term US real interest rates.

Our base case is for US inflation to rise, but only at a modest pace. While it is getting more difficult for companies to hire workers, the labor market has more slack than originally thought. Given this, along with stable long-term inflation expectations and persistent global demand for safe assets, we do not expect US 10-year yields to rise much higher. Our 12-month forecast for US 10-year yields is 3.0%. Instead, we expect continued Fed tightening to be reflected in a rise in the two-year Treasury yield, producing a flatter yield curve.

However, in the past month the risks to our base case have risen. Mechanical factors will boost inflation in the months ahead, which could spook markets, particularly given the recent increase in oil prices. And real 10-year yields have risen by 19bps in the second quarter alone. The US Treasury has increased issuance to fund the fiscal deficit, and the debate at the Fed about the right “neutral” level for interest rates is intensifying. New governor Randal Quarles has suggested that the Fed’s estimate of the neutral level of rates could be revised higher if productivity improves.

To prepare for the possibility that US inflation exceeds our expectations and leads to an overshooting in US yields, we have made a number of adjustments to our portfolios:

• Close FX strategy overweight euro versus US dollar. Recent Eurozone flash PMI data and the prospect of an anti-establishment government in Italy have added enough additional near-term risk for us to take action by closing this position and waiting for a better entry point. The risk for the euro is that the rise in US dollar real yields and the unwinding of short US dollar positions have further to run. Over the longer term, we will be looking to re-enter the position because the gap between Eurozone and US current account balances is close to record levels, valuations still favor the euro, and institutional investors hold higher allocations to the US dollar than are justified by the US share of global financial assets.
• Close FX strategy overweight in the Brazilian real versus the US dollar. Along with many other emerging market (EM) currencies, the real has come under pressure due to broad US dollar strength. It remains unclear whether the recent pause in rate cuts will be enough to stabilize the currency. In addition, political uncertainty is building ahead of October’s election, and the most market-friendly candidate, Geraldo Alckmin, has been losing ground in the polls.

We also make two further changes:

Within our FX strategy, we close our overweight in the Japanese yen versus the New Zealand dollar and add an overweight in the Japanese yen versus the US dollar.

We are taking profit on our NZDJPY position. We adopted this trade in mid-February when NZDJPY was trading at 78.6. Since New Zealand is more advanced in its economic cycle than most other developed nations, we expected the currency to depreciate as growth momentum faded. This expectation was borne out. With the pair now trading at 76, we believe there is little further upside and so remove the position. However, we are adding an overweight in the yen versus the US dollar. USDJPY is vulnerable at 111, with the yen likely to appreciate as inflation starts to rise. We are already seeing signs of faster wage growth which should allow the Bank of Japan (BoJ) to relax its control of yields. Finally, this position has a dual function, promising alpha if the global economy improves and a hedge character in “flight to safety” periods of volatility.

Add overweight in Canadian equities relative to Swiss equities within our international developed equity allocation.

We expect Canadian equities to see good earnings momentum in the months ahead thanks to the recent increase in oil prices and fixed mortgage rates, which should benefit the energy and financial sectors. These two industries comprise more than 60% of the Canadian market. In contrast, the Swiss market has no oil and gas producers, and only a modest exposure to the sector via industrial component makers. Swiss firms are trading at a 7% premium to their average 12-month trailing PE since 1987. And the market is also skewed toward defensive stocks, which can cause it to lag in times of strong global growth.

These changes create the following overall global tactical asset allocation:

Overweight global equities relative to US government bonds. We expect synchronized economic expansion and strong earnings growth to support global equities relative to high grade bonds. We are becoming less pessimistic on the outlook for US high grade bonds, given that the rate hiking cycle in the US is now advanced. In contrast, as monetary policy starts to normalize outside the US, we expect the greatest downside in non-US bonds. This is reflected in the following position:

• Overweight 10-year US Treasuries relative to cash. We do not expect US yields to move higher in our base case, and see yields of 3.1% as attractive, especially given that Treasuries could provide a valuable hedge to portfolio positions in equities in the event of a negative growth surprise.
• Overweight Canadian equities relative to Swiss equities. As above.
• Overweight EM equities relative to US government bonds. The positive outlook for global growth should continue to support EM equities. They also offer the lowest valuations and highest potential growth of any regional market. Although short-term headwinds are coming from the recent strength in the US dollar, the increase in US yields, and idiosyncratic risks in countries such as Brazil and Turkey, the medium-term outlook remains encouraging. We expect earnings growth of around 15% for EM stocks this year.
• Overweight EM dollar-denominated sovereign bonds relative to US government bonds. EM debt markets offer higher credit rating-equivalent yields than developed markets. We believe that the yield pickup is still attractive.
• Overweight CAD vs USD. The recent increase in the oil price, the strong global growth environment, and attractive valuations should support the CAD vs the USD in the months ahead, although we acknowledge the possibility of shortterm volatility due to ongoing NAFTA negotiations.
• Overweight JPY vs USD. As above.
• Overweight INR vs TWD. India’s improving economic outlook is attracting increased foreign direct investment, while Taiwan could suffer in the event of a re-escalation in trade tensions between the US and China. The position also has an attractive carry of 7.3% per annum.

Please visit ubs.com/cio-disclaimer